Posted by Marc Hodak on September 10, 2007 under Economics | 
McKinsey people strike me as real smart. And they dress well. And they make impressive presentations. And then they come up with this stuff:
How to choose between growth and ROIC:
One key to creating value is understanding how to manage the subtle balance between growth and returns on invested capital. Empirical evidence suggests that companies enjoying strong ROIC can afford to let it decline over the short term to pursue growth—and that companies with low returns are better off improving ROIC than emphasizing growth.
Duh. They presumably let us in on this Finance 101 factoid as a way of letting managers know that maximizing either on growth or on returns is not necessarily optimal. Presumably, you can hire McKinsey to find out which one–growth or returns–is your best bet right now.
Or, you can choose to maximize EP. That always gets you the right answer. EP is the excess return scaled up by the amount of investment:
EP = (Return on capital – Cost of capital) x Capital.
EP provides the perfect balance between growth and returns. If your growth (in Capital) is associated with returns less than your cost of capital, your growth may or may not be enough to compensate for your lower returns. All you have to do is check the EP formula. Similarly, if your returns go up because of a drop in Capital (i.e., negative growth), it’s not obvious if your ahead or not. Check the EP formula. EP always gives you the right answer, even in a changing environment, even with a changing business model. You don’t have to hire McKinsey for this.
So, is McKinsey stupid? Don’t they know this? Of course they do. But telling clients whether to pursue growth or returns is like giving them a fish. Giving prospective clients the right measure that balances growth and returns so they can figure it out themselves is like teaching them to fish. McKinsey didn’t become the biggest fish by teaching their clients how to fish.
Posted by Marc Hodak on September 8, 2007 under Practical definitions |
This colorful sign is posted at airports and rail stations all over the country, so I’ve been seeing it a lot recently. I wonder if it means anything at all? I mean beyond the CYA function it serves our politicians. That I understand: As long as the threat level is “Elevated” or worse, our senior public officials have a magic pass to turn responsibility into blame if anything bad happens. Instead of saying “We failed you,” as they do in more honorable societies, our politicians get to say “I told you so.” See the difference? “We failed you.” “I told you so.”
In a society where authority comes with accountability, the incentive is for people to be careful about how much authority they assume. In a society where grabbing authority comes with little incremental accountability, you get…Homeland Security, the FDA, OSHA…
Websters defines risk as “possibility of loss or injury.” That broad definition means different things to different people. So, here are two versions of the expanded definition of risk:
Risk (scientist): A probability of loss or injury; often used to trade off against the probability of gain or reward
Risk (politician): The likelihood of loss or injury; easily used to justify more power or tax funding
The political view is immediately distinguished from the scientific one by its reliance on availability bias. Nowhere is this scientist/politician distinction better illustrated than our Homeland Security Advisory System. From a politician’s point of view, there is always a possibility of terrorist attack. Beyond that, their assignment of a color code appears to be based on a secret lotto wheel or big, fuzzy dice with only three possibilities: “Elevated” “High” and “Severe.”
Scientifically, what we’ve experienced with this color-coded system makes no sense. Sure, they’ve been very good at raising the alert after an incident occurs, but what good does that do anyone? We have been never been below Yellow alert–an “elevated” risk. For most of the time since the system has been put into place, we have been on Orange alert–“High” threat. After five years of this nonsense, we have plenty of data on threat levels vs. actual incidents. You’d think there should be a correlation between the two. Anyone care to guess what that correlation is?
Posted by Marc Hodak on September 4, 2007 under Unintended consequences |
Today, a writer for the WSJ inked a piece about the rise in premiums for wind coverage. The author discusses how much the premiums have gone up and what people are doing in response to the increase in premiums, etc. In 1300 words, the author never mentions a major contributor, if not the most likely cause, of the dramatic increase in premiums. He simply takes it for granted, as most of his readers presumably do, that a company dropping clients and foregoing business via significant price increases requires no explanation. At least that’s a step better than most journalism that would assume that the explanation is some sort of conspiracy by the insurance companies to make more money.
The basic problem is that this article is all about the property the author could see–the real estate that had been damaged, or might be damaged, and was going uninsured. What is missing is the notional property that is a contract. Insurance companies contract with homeowners to insure their property for possible future damage. In this case, the source of that damage would be wind; insurers aren’t supposed to be on the hook for water damage. When a hurricane comes along, the wind comes with water, and it’s sometimes difficult to distinguish the source of damage. When enough citizens plead with enough politicians to insist that the insurers err heavily on the side of assuming wind damage, the insurers pay out the nose for damage they did not insure. Ever heard of this happening? Oh, after every hurricane.
So, insurance companies, in an rabid attempt to protect their profits, now have to assume that “wind” means “wind or water,” and must, if they have a shred of concern for their shareholders, charge accordingly . Why else would they raise their premiums? Well, the newspapers often get this wrong. They say companies must raise their premiums after a bad storm to help pay for those (past) damages. That, of course, makes zero economic sense. Insurance is a prospective game. If I were to enter the market and offer to insure you for wind damage, basing your premiums on the actuarially correct amount needed to cover your expected losses with a profit for my risk, then I would kill off all my competitors overcharging you based on past, unrecovered damages, i.e., their sunk costs.
Of course, the state won’t let me just start up a competing insurance company. The regulatory hurdle is simply too great. And the insurers would rather feed you the story about having to pay for past damages because, unlike my readers, that is all the average reader understands. They simply wouldn’t have the patience to learn the economics of insurance markets from scratch. I don’t blame the insurance companies. I blame the boards and trustees of schools that refuse to include basic econ in the curriculum. Like the school this article‘s author no doubt attended.
Posted by Marc Hodak on August 31, 2007 under Economics |
The AP story begins with the silliest possible headline: “Stocks End Up on Bush, Bernanke Speeches.”
Actually, stocks opened higher, well before either speech, and drifted sideways through the day. So, there is no basis for implying that the stocks were up because of the speeches, unless you assume that the market got copies of the speeches before they were actually given by Bernanke and Bush.
Even if that were true about the Bush speech, let’s look at what he actually proposed to deal with mortgage problems:
1. Expanding FHA lending to a number of home-owners not previously covered
2. Supporting legislation to change tax law on forgiven debt
3. Strengthening lending standards for loans to low income individuals
Here is the translation:
1. Shifting more of the risk from private banks to the taxpayers
2. Inserting into our 67,000 page tax code another couple of lines that read like, “Enter on line 16g the total interest expense (including interest equivalents under Temporary Regulations section 1.861-9T(b)). Do not include interest directly allocable under Temporary Regulations section 1.861-10T to income from a specific property…”
3. Insuring that whatever steps the market would naturally take to prevent something like this from happening any time soon is associated with additional regulatory paperwork, risks, costs, and constraints so as to artificially depress the number of loans that will be available to the poor on any terms.
That’s what the AP reporters thought the market was applauding?
Oh, we don’t get far into this story before encountering this nugget:
Read more of this article »
Posted by Marc Hodak on August 30, 2007 under Invisible trade-offs |
From this story, we see where a good education can get you:
Karsnia, 29, joined the airport police department just out of college in 2000 and was promoted to sergeant in 2005. Last year, he earned a master’s degree in criminal justice, leadership and education.
He has arrested at least a dozen men in the airport’s bathroom for sending signals he believed were aimed at initiating sex.
So, a police sergeant with a master’s degree and five years experience is sitting in an airport john all day waiting for someone to tap his toe? Not exactly in the same league of boyhood dreams of being an astronaut, fireman, or cop…uh, at least not the kind of cop you see on TV.
Of course, with leadership training, one might decide it’s not enough to wait for the fly to come to the honey. If you’re after gay men, how much does it take to reel them in? I mean, if gay men are as promiscuous as hetero men (maybe a gay commenter can fill me in on this one), then entrapment can’t be very difficult. I know that if it were illegal to initiate a heterosexual encounter in a public place, it wouldn’t take much for a cute female cop with “leadership” training to quickly net a horde of defendants.
Couldn’t we have these people with master’s degrees selling hot dogs, or washing windows, or cleaning gum off the sidewalk, or anything that actually improves our quality of life rather than adds to a climate of fear and mistrust?
Posted by Marc Hodak on August 29, 2007 under Practical definitions |
OK, let’s take a look at the logical content of this statement:
My opinion is that when you plead guilty to a crime, you shouldn’t serve. That’s not a moral stand. That’s not a holier-than-thou. It’s just a factual situation.
That was Senator John McCain. The guy who wanted to be our president.
Here is clue, John: Any statement that includes the word “should” (or “shouldn’t”) is a moral stand. “Should” statements are not factual. You should go back and get some education.
And, by the way, anyone who says their attitude is not “holier-than-thou” doth protesteth. But, apparently, they can still get lots of votes.
Posted by Marc Hodak on August 27, 2007 under Unintended consequences |
Actually, the quote was this:
As long as I am allowed to redistribute wealth from out-of-state companies to in-state plaintiffs, I shall continue to do so.
– Chief Justice Richard Neely, West Virginia Supreme Court
I wonder what percentage of people in or out of WV would characterize Justice Neely’s statement as being friendly to WV’s interests? Probably a majority.
On the other hand, it would be difficult for someone with economic sense to not connect the dots between:
– hostility to outside capital
– outside investment in the state
– job and wealth creation in the state
So, it would not be surprising to someone with economic sense that WV’s notable absence of the rule of law may somehow contribute to that state’s ranking 49th in median household income.
One of the things I teach in my class is how corporate behavior is naturally and significantly regulated by repeat transactions. If you want to keep your customers, employees, vendors, and shareholders, you better take reasonable care of them–at least as good as the next guy. It’s amazing to me how many elected officials ignore this fact of competition, as if the competition for capital weren’t real. It’s amazing until you see the incentives of the election process. Justice Neely, for instance, was elected by the citizens to whom he redistributed that wealth, and his campaigns were funded with the money from settlements that he delivered by the local lawyers who appeared in his court. Whether or not Neely believed in redistributive “justice,” it’s unlikely that the system would support someone in his position who didn’t.
Posted by Marc Hodak on August 23, 2007 under Practical definitions |
Megan McArdle has really stepped into the collectivist swamp in her new gig at The Atlantic. Just check out the responses to her posts. Part of the problem is that she is speaking in a slightly different language from that of The Atlantic’s normal readers. So, here are some basic definitions of certain terms that appear to be causing at least some of the confusion.
Self-interest: You doing what you want to do.
Enlightened self-interest: You doing what I want you to do.
Social contract: Those with political power telling everyone else what to do.
Contrast the last definition with this:
Brute-force collectivism: Those with political power telling everyone else what to do.
I hope that helps.
Posted by Marc Hodak on August 20, 2007 under Futurama |
In three months, Max has gone from lofty, cum laude senior to lowly frosh having to prove himself all over again. Today we make the eight-hour drive down to his new school. We’d have flown him down, but he’s got the accumulated STUFF of a post-industrial teen who happens to be both very athletic and crazy-smart with computing technology. Also, he’s going away! By driving him down, I get a couple more days with him.
Many years ago, when the big guy was much smaller and more daddy-centered, and our worlds largely overlapped, the thought of this day would have inspired dread. Now that it’s time to cut him loose, and for us to become visitors in each other’s separate worlds, it’s not as bad as I thought. First of all, it’s not exactly a cold-turkey split. Max weaned us with a stint at boarding school these last couple of years. His school was only an hour away, so this still feels like a big step, but not nearly as big as “now-you-see-me-now-you-don’t.” Second, communications have changed a lot since the time of mini-Max; every kid now has a cell phone and Al Gore has invented the Internets!
I’ll try to set a good example while I still have some parental influence, and not use my phone while driving.
Update: Eight hours turned out to be wishful thinking. Traffic was thick, even without the expected rains. Thank goodness, we’ll only have to move his STUFF once in these next four years. At least the Internet is working down here.
Posted by Marc Hodak on August 17, 2007 under Economics |
So, the Fed is watching the meltdown in our credit markets, feverishly pumping billions into the economy to keep the dollar in the target range of their arbitrarily chosen prime rate, and now deciding to cut its discount rate on bank loans. Does this sound like the sober, measured response of a technician adjusting some dials–the image of the Fed we have all been led to believe?
To me, it looks like my kids reaction when they placed marshmallows in the microwave. It was cool when they put in one, and it swelled up. Then they put two. Then four. Finally, as the marshmallow mass expanded out of control, they were feverishly trying to manage it with the “Start/Stop” button to prevent it from either deflating into a crisp cube of sugar, or blowing up in a big mess. The incentives were pretty weak on this trade-off, considering who would actually be cleaning up any mess.
The story machines we call our newspapers are labeling this the “sub-prime” mess. For months now, when the market has gone down, the headlines have been, “Markets Weighed Down by Sub-Prime Woes.” When markets went up, we’d read, “Markets Shrug Off Sub-prime Concerns.” It’s like the story-writer’s union has decided that this whole market is about “sub-prime,” and they created a serial based on that character to feed to AP, Reuters, etc.
For those of you who’d prefer financial news to financial entertainment, here’s the scoop: It’s not a “sub-prime” mess. It’s not even a sub-prime mess “spreading” to other markets. It’s a credit bubble that every banker and deal maker has seen slowly blowing up for the last four years. There was never any question in their minds about whether or not the thing would pop, only when and how bad. Well, when is now. How bad remains to be seen.
It never really mattered that the people over-borrowing were the folks in plaid shirts who couldn’t afford the home (or second home) they were trying to buy, or LBO artists in $5000 suits with those wonderful track records, i.e., somehow managing to make gobs of money by leveraging up during the recent bull market. All that mattered were that those loans were ultimately all based on one key thing–the underlying asset values would keep going up.
Now that they have stopped going up, people are all surprised. The first assets to get hit were the most vulnerable–low-end housing–so the economic geniuses in press are reporting that is where the problem “started.” (Have I complained enough about the lack of economic education among the press?) The problem of course started with the first marshmallows, in a world awash with sugar, blowing up nicely, and the kids trying the experiment getting a tasty treat.
Now, the Fedmeisters are standing in front a microwave that has been shoveled-pumped with marshmallows, and all they have is that “Start/Stop” switch to try to keep things puffed just the right amount. Good dad that I am, I’m putting on my gloves and getting out the cleaning fluids.
